At the heart of the Lieberman-Warner Climate Security Act that failed in Congress in 2008 was this market mechanism, designed to penalize businesses that don't cut their CO2 emissions. There's little doubt cap-and-trade will be on the agenda in the new Congress.

In Congress, there is a lot of discussion about a potential cap-and-trade regulation. But let's look at the math. There are about 25 states in this country that get half or more of their electricity from coal. That's 50 votes in the Senate. And if you're the CEO of a coal-fired utility, you have a fair degree of confidence as a result of that math that you're not going to get hit with anything that's going to be, in your view, too draconian. …

[What is the scene in Washington?]

There is an increasing sense on the part of industry that industry is going to get hit with a cap-and-trade program. There's a debate about whether it's going to be a carbon tax or a cap-and-trade program, and I think that most of the money is probably on a cap-and-trade program. …

So then the question is, how does this thing get structured and who gets hit? There are going to be winners and there are going to be losers, just like in any big regulation.

And so what you have is lobbyists of every stripe fighting against each other over how to structure this thing. So you have fights between one industry and another. You have fights within one industry between one company and another. You have fights on a global level between the industrialized world and the industrializing world, U.S. and China.

One of the real questions in how it gets structured is how these allowances are distributed. So under the cap-and-trade system, the government imposes a cap, and then it essentially prints up a currency called allowances, which are permits to pollute, and it passes out those permits to industry. One question is, who gets how many? But the other question, the sort of more salient question is, do you have to pay for them or not? And there is a pitched battle going on now that's becoming part of the presidential debate about to what degree industry should have to pay for them.

Coal-fired utilities are pushing strongly not to have to pay for them, to have them allocated, in the lingo, based on their pattern of emissions in the past, which would essentially mean that a coal-fired utility would be able to continue to burn coal -- the theory being that the number of allowances it got would be reduced over time, but that that would be a gradual change that wouldn't be dislocating. It would not force utilities that burn coal to shut down their coal plants and open up gas plants or build wind farms tomorrow.

There is a point of view by others that that's not the way to go, that if the goal is to get to drastic reductions like you were talking about, then the economy needs to be dislocated. And so you should force people to pay for these permits to pollute, and if it's dislocating, so be it.

Well, it would essentially mean that a utility would have to go into some kind of auction and buy these things at some kind of market price, depending on scarcity and demand. And then they would just pass those costs along to the consumer. Right?

Right.

So our electricity rate would go up.

Yes. And that's what happened in Europe. … Utilities were given these permits, and yet the electricity price still went up. There were government investigations of the system. There were cries of what's known as "windfall profits," the concern being that utilities were given permits for free, yet electricity prices rose because of the marginal value of these permits; even though the permits were given to utilities for free, utilities were of the opinion that they could've then gone and sold these permits on the market.

And to the degree that they were not able to sell these permits, because they had to hand them back to the government to comply with the rule, that was effectively a cost, and the price of electricity should rise as a result of that cost. And there was a huge hue and cry in Europe. There were government investigations. And that is, again, a specter that hangs over the whole Washington debate. …

So either way there's a cost to the consumer, or do we expect that in the United States there won't be this sort of charging the consumers for the opportunity lost?

The Democratic position in the presidential race is that there will be auctioning and something close to 100 percent auctioning, which is to say that no permits will be given for free. There is less certainty on that point on the Republican side, but it's pretty clear that the trend is toward more charging rather than more giving out for free.

And the question then is, does that happen? Is that just a campaign trail platitude? When someone gets in the White House, are they presented with the reality of the Senate votes and the hue and cry from coal-fired states, … or do they push this through? …

… And what have we learned from Europe?

We've learned that it is tough for reality to match the rhetoric. There were aggressive ideas about how the government was going to stick it to industry in reducing CO2 emissions three years ago, when Europe went down this road. And what's largely happened is that industry prevailed on government to soften those standards.

It was not working?

… It's working or it's not working, depending on where you approach this from. It's not working in the sense that … the amount by which Europe is reducing its emissions is having a negligible effect on global warming.

It's working in the sense that … it is a foot in the door toward assigning a price to carbon, with the idea that the next foot will follow and the next and the next. And the price of carbon will rise because government will lower the cap, toughen the cap, and once we get down that road, industry, in fact, will be forced to change fundamentally how it does business.

You went to Europe. You looked at their system. There were major problems with their free allocations because the companies took those allocations, then sold them and made windfall profits off of that. How do you prevent that?

What actually happened in the European Union is that the allowances were assigned for free to the emitting sources. And so the electric utilities did not incur a charge for the acquisition of those allowances. They were given to them. ...

But they then passed those allowances through to their ratepayers in the form of the opportunity cost of not selling that allowance in the market. So they never actually sold them. They kept the allowances. They had to surrender those to the regulatory board.

They essentially sold them to their customers.

They essentially charged their customers for a phantom cost that they didn't actually incur. And in my view, that was wrong. I think that windfall profit was not justified.

We are looking for mechanisms here that, if we decide that the allocations will be awarded without charge, and will not be auctioned, that we can prevent that kind of pass-through of opportunity cost from occurring.

Isn't a cap-and-trade system a way of getting companies to look more seriously at energy alternatives?

It probably is in that way, yes. It probably is.

So you're not opposed to it. You just think it might not work very well?

I think it will be difficult, because anytime the government designs something and puts it out there, then the first cut at it is, oh, my God, what do we have to do to conform to it? What are the ways we can circumvent this? What are the ways we can beat this? Do they have any loopholes in this?

And they go to work on them, OK? They find loopholes. Then we have more regulations that come on top of that, and it just stacks up, and it becomes horribly expensive.

So when Washington changes the rules, business gains the --

Sure they do. Sure they do.

Eric Pooley
Former managing editor, Fortune magazine

You've got to provide a soft landing of some kind?

Provide a soft landing for industry and also for consumers. The eco-populism idea that I mentioned would take a lot of the proceeds from a cap-and-trade and give them back to the American people in the form of an annual dividend. You might call it cap-and-cash back. And that annual dividend is kind of like what Alaska does for every man, woman and child in the state -- getting an annual dividend from oil revenues.

In this sense it would be a dividend that would serve to cushion the blow for higher energy costs over the short term. And it may be a way to galvanize Americans and [have them] say: Well, there's something in it for me here. It's not just saving the planet long term. It's helping my pocket book in the short term.

That could be a bold, positive, transformative economic message: We're not just going to fix this solution long term; we're going to make things a little better for you when you're sitting at the kitchen table doing your bills once a month.

And cap-and-dividend or cap-and-cash back could be a very powerful message. And I think you'll see it be one of the defining terms of the debate when we begin to take up climate legislation next year.

If CO2 is a huge problem -- and it is; I think that by and large the world is now convinced of that -- then it is a very logical approach that, initiated by governments, that industry can help. You price CO2 because that will enhance energy savings. ... It may give more space for non-CO2 energy forms to make more rapid market penetration.

And that is not only what we say to the world; we do the deeds as well. Shell was very closely involved in setting up the European trading scheme where, basically, you price CO2. There are still all kinds of … problems. But over time, we will get it right. And in general, we are even publicly advocating … CO2 trading systems, so pricing CO2 is very beneficial because of the high CO2 concerns.